An Empirical Analysis of the Pricing of Collateralized Debt Obligations

ABSTRACT

We use the information in collateralized debt obligations (CDO) prices to study market expectations about how corporate defaults
cluster. A three‐factor portfolio credit model explains virtually all of the time‐series and cross‐sectional variation in
an extensive data set of CDX index tranche prices. Tranches are priced as if losses of 0.4%, 6%, and 35% of the portfolio
occur with expected frequencies of 1.2, 41.5, and 763 years, respectively. On average, 65% of the CDX spread is due to firm‐specific
default risk, 27% to clustered industry or sector default risk, and 8% to catastrophic or systemic default risk.